Possession Is 100% of the Tax Law

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In a case dating back to a lawsuit filed in 2000, the Tax Court has ruled on the matter of accruing disputed payments involving barge-maker Trinity Industries, an accrual method taxpayer, and its customers J. Russell Flowers Inc. and Florida Marine Transporters Inc. (FMT). The case facts are as follows: in Trinity Industries and Subsidiaries v. Commissioner, 132 T.C. No. 2 (2009), Trinity Industries entered into a series of contracts to build barges for Flowers and FMT. Payment was due upon delivery of the flat-bottomed boats, and Trinity duly delivered the barges on various dates between September 1997 and March 2000.

Trinity accrued and reported the sales income in the year in which it delivered the barges. Then, on May 22, 2000, Trinity entered into a second contract with Flowers and FMT. The contract price in each case was $1.29 million for each barge, with $1 million to be paid upon completion and acceptance of each barge and the balance within 18 months of delivery.

After the execution of the second contract, serious problems developed with the barges that Trinity had sold to Flowers and FMT under the first contracts. Lawsuits and countersuits were filed. On March 12, 2004, Trinity and FMT entered into a settlement agreement in which Trinity agreed to credit FMT with the $2.2 million of unpaid deferred obligations to which FMT had asserted a “right of offset.” In other words, the deferred payments had been withheld by FMT.

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As a result, FMT agreed to pay Trinity the remaining $617,000 balance over a period of 12 months. On April 28, 2005, Trinity and Flowers entered into their own settlement agreement: Trinity agreed to repurchase certain barges sold to Flowers under the first contracts and pay Flowers $5,764,000 in damages. Flowers, in turn, agreed to pay Trinity the $8,020,000 it withheld under the second contract.

With respect to barges delivered under the second contract in 2001, Trinity accrued the full amount of the sales — including deferred payments — and reported those amounts as income (for federal income-tax purposes) in 2001. However, with respect to barges delivered under the second contract in 2002, Trinity reported as income only the amount received during 2002. That means Trinity excluded the deferred payments to which Flowers and FMT asserted rights of offset. The government objected to this approach to reporting income and the Tax Court upheld the government’s objection.

“Before a taxpayer may transfer money ‘beyond its control,’ it must first have the money ‘within its control.'” — Robert Willens

All Events TestThe issue is whether Trinity, an accrual basis taxpayer, was required to accrue in 2002 deferred payments for barges it delivered under the second contract in 2002 — the payments Flowers and FMT (the obligors) claimed as rights of offset. Under the accrual method of accounting, income is recognized when “all the events” have occurred that fix the right to receive the income and the amount can be determined with “reasonable accuracy.”

Here, Trinity’s delivery of each barge unconditionally fixed its right to receive the full contract price under the second contract. However, Trinity accrued only the payments received upon delivery and excluded the deferred payments. This was not appropriate.

Neither Flowers nor FMT ever disputed the fact or amount of its obligation to Trinity under the second contract. Their filings in the litigation expressly acknowledged their obligations and indicated they were “setting the withheld amounts aside in escrow or as collateral security” to offset whatever damages Trinity may ultimately be determined to owe them with respect to their claims under the first contracts. The court concluded that Trinity “effectively received” the withheld amounts when they were applied in compromise of Flowers’s and FMT’s claims. In the final analysis, the court found, the “offset claims” affected only the timing of Trinity’s receipt of income and not its right to receive the income.

Indeed, an accrual basis taxpayer must accrue income once the all-events test is satisfied. However, accrual might not be required if the income (the right to receive which has become fixed) is of “doubtful collectability.” Though in this case, the evidence did not show that Flowers or FMT was insolvent or bankrupt, or that the collectability of their debts was otherwise “called into question” by their financial conditions. Accordingly, the doubtful collectability exception to accrual of income was unavailable here.

Moreover, the court noted that Flowers and FMT asserted their claims of offset only after the barges were delivered and Trinity’s right to income had become fixed. Accordingly, postponement of accrual, in this case, is wholly unjustified.

Contested LiabilityTrinity had one last arrow in its quiver but its aim was found to be faulty; that is, Trinity contended that based on Section 461(f) of the tax code, it was entitled to deduct $4,520,000 in 2002 on the grounds that it transferred that amount to Flowers and FMT in satisfaction of their disputed claims for damages. Section 461(f) permits a taxpayer to deduct a “contested liability” provided the taxpayer has transferred amounts in the same taxable year to satisfy the contested liability.

Here, the $4,520,000 of deferred payments to which Trinity claimed a deduction came due in 2003 and 2004; Flowers and FMT, the court noted, cannot be said to have withheld the deferred payments before they came due. Further, Section 461(f) allows a deduction only for the taxable year of the transfer. Consequently, the court stated, “even if we were to agree that the withheld payments represented transfers we would conclude that the transfers occurred in 2003 and 2004.”

In any event, the court disagreed with Trinity’s contention that the withholding of the deferred payments represented a transfer. It observed that before a taxpayer may transfer money “beyond its control,” it must first have the money “within its control.” In this case, however, the deferred payments were never in Trinity’s control. Accordingly, no deduction under the authority of Section 461(f) was allowed to Trinity for its 2002 tax year. Thus, the disputed payments had to be accrued in 2002 and no offsetting deduction, available under the auspices of Section 461(f), could be claimed to offset this income.

Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.